Whether, and to what extent, crypto-asset tokens are subject to financial services regulation is a subject of wide debate and a degree of controversy. As a result, it can sometimes be difficult for a crypto-asset market participant to determine whether it falls within the scope of financial services regulation. In this regard, one of the main issues for such participants is whether or not they fall within the scope of the EU’s revised Markets in Financial Instruments Directive 2014/65 (the “Directive”) and Markets in Financial Instruments Regulation 600/2014 (collectively, “MiFID”). This briefing sets out a number of Q&A which we hope will help crypto-asset market participants considering this issue.
What is a Crypto-Asset?
A crypto-asset is a type of private asset that depends primarily on cryptography and distributed ledger technology (“DLT”) as part of its perceived or inherent value. Crypto-assets are frequently classified into three categories or tokens, namely:
- Security tokens – instruments which indicate an ownership position in an entity, a creditor relationship with an entity or other rights to ownership or profit;
- Payment or exchange tokens – instruments that are designed to be used as a medium of exchange and that are not backed by any central authority; and
- Utility tokens – instruments that grant holders access to current or prospective products or services.
What is MiFID?
MiFID sets out the regulatory framework for banks and other investment firms that provide services to clients in relation to financial instruments, as well as for certain firms dealing in such instruments on own account. The Directive has been transposed into Irish law by the European Union (Markets in Financial Instruments) Regulations 2017.
If a crypto-asset token falls within the definition of a “financial instrument”, any person providing investment services involving that token may need to be authorised under MiFID, including, for example, broker-dealers, investment advisers, portfolio managers and trading platforms.
What is a financial instrument for the purposes of MiFID?
MiFID lists a number of instruments that are considered to be financial instruments (a “MiFID Financial Instrument”), including, in particular transferable securities, units in a collective investment undertaking and many derivatives.
However, it is not always clear when a crypto-asset token will be a MiFID Financial Instrument. In Summer 2018, the European Securities and Markets Authority (ESMA) conducted a survey of the national competent authorities of EU Member States, to better understand the circumstances under which crypto-assets may qualify as financial instruments. ESMA published the results of that survey, together with Advice on Initial Coin Offerings and Crypto-Assets on 9 January 2019 (collectively, the “ESMA Advice”).
It is important to remember that when considering whether or not a crypto-asset token is a MiFID Financial Instrument it doesn’t matter how a token is described but how it functions. In addition, certain tokens that may not start out as a MiFID Financial Instrument may become one over time.
When will a crypto-asset token be a transferable security for the purposes of MiFID?
To be a “transferable security”, a crypto-asset must fulfil the following requirements:
- the crypto-asset must belong to a class of securities - to form a class, tokens must be fungible with one another, issued by the same issuer, show similarities and give access to the same rights to the same group of investors;
- the class of securities must be capable of being negotiated on the capital markets – this is not always clear. Generally, the abstract possibility of the token being traded could be considered sufficient for it to be “capable of being traded”, even if there is not yet a specific market for the product or there is a temporary lock-up. Moreover, the term “capital markets” may be broad enough to include any place where buying and selling interests meet (including an on-line exchange); and
- the crypto-asset must not be a payment instrument – examples of a payment instrument include a cheque or bill of exchange.
Examples of transferable securities include shares and equivalent securities, bonds and other forms of debt instruments and certain other types of securities.
According to the ESMA Advice, broadly, a crypto-asset that has attached profit rights is likely to be considered a transferable security, once it is part of a class of securities that is capable of being negotiated on the capital markets. In particular, it is not necessary that the relevant token confer ownership or control rights for the token to be considered a transferable security. However, pure utility type crypto-assets are unlikely to constitute transferable securities.
When is a crypto-asset token a share or unit in a collective investment undertaking for the purpose of MiFID?
A collective investment undertaking is an undertaking that pools together capital raised from its investors for the purpose of investment with a view to generating a pooled return for those investors; in circumstances where the unitholders or shareholders of the undertaking – as a collective group – have no day-to-day discretion or control over the undertaking.
Where a crypto-asset token allows a number of investors to pay money or assets towards a venture (whether a company or not) and those monies/assets are used to generate a return that is then paid out to holders, this token could be considered to be a unit in a collective investment undertaking and therefore a MiFID Financial Instrument.
When is a crypto-asset derivative contract a MiFID Financial Instrument?
A derivative is a financial contract between two or more parties that derives its value from an underlying asset. For example, an agreement to buy or sell a particular cyrpto-asset at a predetermined price and a specified time in the future constitutes a derivative contract.
A crypto-asset derivative contract is capable of being a MiFID Financial Instrument, such as, for example, a Contract For Difference (CFD). Other types of derivative contracts will only be a MiFID Financial Instrument if the relevant underlying crypto-asset falls within one of the categories listed in Section C of the Directive, which include securities, currencies, and commodities as well as measures and indices. In this respect, a derivative contract with a crypto-asset security token as an underlying asset could constitute a MiFID Financial Instrument. Moreover, according to the French national competent authority (AMF), a crypto-currency could be a MiFID Financial instrument by virtue of Section C(10) of the Directive, as a "measure" or "index", where the derivative contract satisfies the other conditions applicable to that Section. However, it appears unlikely that a crypto-asset will qualify as a currency and opinions are divided as to whether a crypto-asset can itself be a commodity.
What happens if a crypto-asset token is a MiFID Financial Instrument?
Where a crypto-asset token qualifies as a MiFID Financial Instrument, any entity providing an investment service or carrying on an investment activity with respect to the relevant crypto-asset will need to be authorised as an investment firm, unless it benefits from an exemption.
Does a platform that trades a crypto-asset token that is a MiFID Financial Instrument need to be authorised under MiFID?
According to the ESMA Advice, ESMA’s preliminary view is that platforms that trade crypto-asset tokens that are MiFID Financial Instruments, and which have a central order book and/or match orders under other trading models are likely to require authorisation under MIFID as a Regulated Market (“RM”), a Multilateral Trading Facility (an “MTF”) or an Organised Trading Facility (an “OTF”).
In addition, where the operators of a cyber-asset trading platform are dealing on own account and executing clients orders in crypto-assets against proprietary capital, they could qualify as broker-dealers providing the MiFID services of dealing on own account and/or the execution of client orders and would need to be authorised as such.
What kind of requirements does MiFID impose on firms authorised as an investment firm, RM, MTF, or OTF?
Firms authorised under MiFID must comply with a range of requirements including minimum capital requirements, corporate governance and organisational requirements, conduct of business requirements and transparency and reporting requirements.
Does any other legislation apply to a crypto-asset token that is a MiFID Financial Instrument?
Yes, there is a range of other financial services legislation that could apply to the issuer of a crypto-asset that is a MiFID Financial Instrument, and/or firms providing investment services/activities in respect of those instruments. This includes: the Prospectus Directive 2003/71; the Transparency Directive 2004/109; the Market Abuse Regulation 596/2014; the Short Selling Regulation 236/2012; the Central Securities Depositories Regulation 909/2014; and the Settlement Finality Directive 98/26.